It amazes me how little the average person really understands about the money that comes out of their paycheck for taxes. You probably appreciate far less how much in taxes your employer pays on your behalf. Most of this was a pretty big mystery to me until I went to work for a small CPA firm and started preparing payroll tax returns. I probably now know more than I ever wanted to about the subject, but I sometimes wonder why this is not required as part of our basic education before entering the workforce. You shouldn’t have to be an accountant to understand your paycheck.
Most of us probably have Social Security, Medicare, federal withholding, state withholdings, and other state/local taxes withheld from our checks every payday. Granted, some government employees receive some reprieve and/or pay some alternative taxes, but this discussion is for the average American corporate employee. Keep in mind there are many exceptions to the rule, and if you are reading this article and scratching your head, this is probably why.
For 2007, the first $97,500 you earn will be taxed at a rate of 6.2% for Social Security. It doesn’t matter if you are so young that you will most likely never see that money again. If that upsets you, your only recourse is to write your Congressman. On the other hand, the good news is once you pass the threshold for the year, the tax will no longer be withheld from your check. Until next year anyway.
The Social Security rate of 6.2% has held steady for quite some time, but the threshold tends to increase every year. Social Security taxes are paid on an individual level; there is no discount for being married. If you and your spouse both make $90,000, then your wages will both be fully taxed by Social Security. Social Security withholdings are sometimes referred to as OASDI (Old age, survivors, and disability insurance) or FICA-SS (Federal Insurance Contributions Act – Social Security).
Next comes Medicare. 1.45% of every penny you earn is paid in to Medicare. There is no threshold. Whether you make $5 or $500,000, the entire amount will be taxed for Medicare at a 1.45% rate. This tax rate has been sitting steady for many years as well. Interestingly, when you receive Social Security income in retirement, a small amount is withheld from that money for Medicare premiums. Not only is this something that never really goes away, but the government is starting to significantly raise the premiums of well-off retirees. The law seems to change with the wind these days so I wouldn’t get too excited about this part yet unless you are already in retirement. Medicare may show up on your paycheck as FICA-MC.
The 401k deferrals and medical premiums deducted from your paycheck may not be subject to income tax, but they are still subject to Social Security and Medicare taxes, which means you still pay the respective 6.25% & 1.45% taxes on these amounts. If you participate in a cafeteria-style benefit plan, however, the premiums may not be subject to Social Security and Medicare. This makes cafeteria plans a better tax deal than standard health insurance. Of course, 401k deferrals and health insurance premiums often come out of your check, in addition to taxes. These are just some examples of other items that will decrease your bottom line.
Then there’s the biggest tax deducted from your paycheck: federal withholding. An abbreviation you may see on your paycheck for withholding is “w/h.” This is the amount of Federal income tax you have withheld from your paycheck on a regular basis. You can adjust your withholdings with a Form W-4 to withhold less or more, but it is best to withhold the amount you expect you will owe for the year.
The good news in all this is that you are not funding social security by yourself. Your employer matches your Social Security and Medicare contributions. Your employer actually submits payroll taxes within a week, or month, of every paycheck issued. However, your employer has until the end of the year to prepare your W-2. This is how they report to the government how much you were paid, and how much tax was withheld from your checks for the year. Your employer needs to prepare your W-2 by the January 31st deadline, and the IRS uses this info to compare against the income and tax withholdings you report on your income tax return.
If you are self-employed, then you have the joy of matching your own Social Security and Medicare taxes, and paying the “employer match” yourself. This is the hefty self-employment tax that you pay in addition to income taxes.
In addition to matching your Social Security and Medicare (switching back to the non-self-employed) your employer also pays Federal Unemployment Taxes and State Unemployment taxes. These amounts are based on small percentages of your paycheck.
This leads me to the state taxes withheld from your paycheck. In California you will have State Disability Insurance (SDI) withheld from your paycheck. In New York City you will actually have city taxes withheld from your check. Every state and locality is different of course. In many states you will also have state withholding for state income taxes, similar to federal withholding. However, if you live in a no-income-tax state, then you luck out (well, at least when it comes to your paycheck). For those of you who pay in-state income taxes, you’ll know if you still owe or are due a refund instead, when you file your state income tax return. Employers remit these taxes on a quarterly and/or annual basis, depending on the state.
Sometimes if you work for multiple employers, too much Social Security or state/local tax is withheld from your various paychecks. In general you are allowed a refund of these amounts on your income tax forms. There is a space on the forms to claim these amounts under the line item for taxes withheld. If you don’t catch an instance of over-withholding, hopefully your tax preparer or tax software will. Of course, if you ever notice a payroll tax error during a tax year, you can request your employer to fix it before year-end. If the error is due to the fact that you have more than one employer though, you generally have to wait to file your tax return to get your money back.
It’s important to know what all these items are and what portion of them is your responsibility so that you can catch any mistakes that occur and you can apply for any refunds that you may have due. If you see money is being withheld from your paycheck and you can’t understand why, it’s worthwhile visiting your personnel office to get an explanation. By becoming better informed about how money is taken out of your paychecks, you’ll be in a better position to take control of your finances.